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Solving the Scalability Trilemma

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Will cryptocurrency regulation promote or stifle innovation?

Tokenization is already bringing blockchain to institutions, with financial giants like Nasdaq developing decentralized infrastructure for trading stocks and shares.But in the opposite way, security tokens could also eventually act as a bridge bringing institutions to the heart of blockchain: Cryptocurrency.

Though most security token startups are currently working with permissioned blockchains, the drawbacks of these networks—and the never-ending need for more liquidity and higher security—are likely to lead financial institutions to eventually seek out permissionless blockchains like Bitcoin and Ethereum.

Security Tokens on permissioned chains

The tokenization of equities is appealing for several reasons:

Secure ownership is preserved immutably on the blockchain ledger

Automated compliance can be achieved with smart contracts

Illiquid markets are opened up by letting investors divvy up stakes in hard-to-trade assets like collectible art, or individually buy up a few square meters each of a Tokyo apartment.

Back in December 2017, when bitcoin prices soared as buyers speculated that cryptocurrency was on the verge of widespread adoption, a flaw was revealed in the grand plan.

As the number of transactions peaked, so did transaction fees. To send bitcoin, people were paying an average fee of almost $55, and in some cases waiting several days for transactions to settle.

This bottleneck drew attention to the inherent drawback of decentralization: Just as it is easier for a single person to make a decision than it is for thousands to reach consensus, finding consensus over a decentralized network is slower and more difficult than with centralized systems.

This conundrum is at the heart of blockchain, and was neatly summarized by Ethereum creator Vitalik Buterin.

The scalability trilemma

Buterin coined the term scalability trilemma in the early days of Ethereum to explain the 'impossible trinity' of choices blockchain developers are faced with: Scale, security or decentralization.

The structure of decentralized systems means developers can only optimize for two of these qualities.

While the lack of regulation in the early days of blockchain helped catalyse the development of new platforms and technologies, cryptocurrency has now reached critical mass and appropriate regulation is a prerequisite for large-scale adoption by both retail and institutional investors.

Bitcoin was and still remains a grassroots technology. The network was launched as an experiment in peer-to-peer online money and slowly gained traction over several years – first as a niche interest for libertarians, cryptographers and fiat money sceptics, then later as an alternative financial asset. Since the world had never seen anything like it (in fact, many experts believed the implementation of true digital cash was impossible) it did not fit neatly into any existing regulatory frameworks.

Cambrian explosion

That remained the case for several years. The lack of regulation undoubtedly helped push the sector forwards, and the early era of blockchain saw a ‘Cambrian explosion’ of new ideas and platforms. This was an exciting period of intense and en...